Who's the Second Biggest Wearables Maker in the World? (Hint: It's Not Apple Inc. or Samsung Electronics Ltd.)

Many investors probably know that Fitbit is the largest wearables maker in the world. According to IDC, Fitbit's shipments rose 129% annually to 3.9 million devices in the first quarter of 2015, claiming over a third of the global wearables market. But here's the twist -- the second largest player after Fitbit wasn't Samsung (NASDAQOTH: SSNLF), Apple (NASDAQ: AAPL), Garmin (NASDAQ: GRMN), or Jawbone.

It was actually Xiaomi, China's top domestic smartphone maker. Xiaomi, which launched its Mi Band last July, shipped 2.8 million fitness bands during the first quarter and claimed 25% of the entire market. That put it far ahead of Garmin, Samsung, and Jawbone, which respectively had market shares of 6%, 5%, and 4%. How did Xiaomi gain ground so quickly, and how could other companies be affected?

Xiaomi's Mi Band. Source: Xiaomi

The rise of Xiaomi's Mi Band
Xiaomi's Mi Band, which costs just $15, is a basic activity and sleep tracker that uses three LED lights to track progress and syncs to a companion app. By comparison, Fitbit's Zip activity tracker, which has a digital display, costs $60. Jawbone's Up Move and Misfit's Flash, which both use LED lights, cost $50.

That low price tag made the Mi Band an instant hit in mainland China. Xiaomi has since launched the device in Hong Kong, Taiwan, Singapore, Malaysia, Indonesia, and India. The Mi Band also recently reached Western markets through Xiaomi's new online stores in the U.S. and Europe.

Xiaomi can sell the same tech as its rivals for such a low price tag because it is willing to accept lower margins. Most fitness band makers are actually selling their devices at huge margins. Based on an IHS teardown from late 2013, the $100 Fitbit Flex only cost $17 to manufacture. Since then, component prices have likely declined, allowing Xiaomi to make a thin profit from selling similar hardware for just $15.

Xiaomi's Mi Fit app. Source: iTunes

Xiaomi applies that strategy across its entire product line. It sells smartphones and tablets with comparable hardware as top flagship devices for a fraction of the price. It sells 55" 4K smart TVs for $800 when competing devices cost $1,000 to $2,000. Xiaomi sacrifices margins for market share growth, and as volumes pick up, economies of scale kicks in and it squeezes out profits where lower-volume rivals cannot.

How Xiaomi could kill Fitbit
The wearables market is usually split into three categories: activity trackers, higher-end sports performance devices, and smartwatches. Research firm Generator Research believes that out of those three categories, revenue from basic activity trackers will plummet over the next five years.

Source: Generator Research

The problem is that cheaper smartwatches could cannibalize the market for stand-alone activity trackers. The Pebble Watch, for example, already merges smartwatch and fitness tracking features into a single $89 device. Hardcore athletes are more likely to buy pricier sports performance devices from Garmin or TomTom, which emphasize function and durability over form. To compete more effectively against sports performance devices and cheap smartwatches, Fitbit launched smartwatchlike devices like the Charge, Charge HR, and Surge last year.

Fitbit's newer devices. Source: Fitbit

Unfortunately, the growing smartwatch category is already filled with Samsung devices, Android Wear watches, and the new Apple Watch. This means that Fitbit might get stuck in a shrinking market as Xiaomi flattens consumer price expectations.

Looking ahead...
The Mi Band might pave the way for the arrival of Xiaomi's long-rumored smartwatch.

For now, companies like Samsung and Apple -- which rely more on smartphones and tablets than wearables -- don't need to worry yet. But "pure play" wearable companies like Fitbit and Jawbone could soon face the commoditization of their core market.